When a policy limit of –30% for net earnings-at-risk is too narrow

A few years ago I wrote a series of posts about how you might set interest rate risk policy limits. In one particular post I echoed this quote from a colleague, “ALCO Policy Limits should be wide enough to be functional, but narrow enough to be meaningful…” Sharing this little observation with anybody involved in bank management usually draws a nod of understanding. However, I think that while most folks agree with the “narrow enough to be meaningful” part, they don’t give the “wide enough to be functional” part much thought. Or, if they do, they think, “yea I know a bank or two that sets their policy limits really wide so they’ll never violate them.” To be fair that’s what I usually think too, and let’s be honest, we all know of bankers that would ditch their policies altogether if the regulators didn’t care. Ignoring ALCO policy is a bad idea, but you do need to consider that “wide enough to be functional” part.

A great example of this came up with a client recently. Their bank is receiving a lot of heat from examiners for 1) having a policy limit that’s too wide and 2) violating that policy and not having a plan to correct it. The ALCO policy in question? A Net Earnings-at-risk limit of –30.0% given a +/-200bp shock. Before you get too alarmed – lets be clear – that’s a net earnings-at-risk policy, not a net interest earnings-at-risk (or margin-at-risk) policy. For a frame of reference, their margin-at-risk policy limit is –15% which is wider than “normal” but certainly not unheard of, especially for a bank that is small and growing.

Here’s a copy of their latest Income Shock Report (click to enlarge in a new window). The bank’s reported Net Income-at-Risk is –97.91% and Net Interest Income-at-risk is –4.82%. The bank is outside policy limits for Net Income-at-Risk and within policy limits for Net Interest Income-at-Risk, hence the pressure from the examiners.

The problem is that Net Income is such a small number compared to Net Interest Income: $319 versus $6,479. Also in the shock scenario we’re applying the same dollar change to each total. The dollar change is $-312. A change of $-312 applied to $6,479 is only a –4.82% change. A change of $-312 applied to $319 is huge…-97.91%. (We apply the same dollar change because in this bank’s model, like many banks, there is little change in items below the margin in the shock scenarios.)

As long as net income remains a proportionately much smaller number than net interest income this is what’s going to happen to the net income-at-risk percentage. Since margin is typically the largest portion of community bank’s revenue it should be no surprise to see that net income-at-risk is much more volatile (ref: 2010Q2 peer data).

To address the regulator’s “concerns” I offered several possible solutions:

A) Give it time Leave the policies in place, but each quarter when reviewing IRR make note of the policy violation. It’s a temporary thing. The bank is still growing and eventually net income will “catch-up”. The bank is also unlikely to continue it’s high level of provision expense indefinitely, currently they are projecting $1,500. Using the back-of-the-envelope if you reduce to projected provision expense back down to a more normal level, say around $300 the IRR measurement quickly comes into line. Essentially add $1,200 back into net income. $319 + $1,200 = $1,519. A change of $-312 applied to $1,519 is –20.53% which is within the policy limit. Be sure to include an explanation of this line of thinking in the ALCO meeting minutes.

B) Change your margin-at-risk limitIf the regulators still feel the –30% policy limit is too wide, then all things being equal, they have to believe that the –15% net interest earnings-at-risk is too wide also. Remember, normally in a shock-test most items below the margin don’t change when rates change, so we’re applying the same dollar change to both margin and net income. In this case if we’re only going to tolerate a –30% change in net income that translates into $-96 ($319 x –30% = $-96). That means that, at the policy limit, we’ll have to constrain or our margin change by the same amount. So a change of $-96 applied to a projected margin of $6,479 is roughly –1.50%. To be consistent the bank would have to change its margin-at-risk limit to -1.50%. That’s quite narrow and basically impossible to manage. Again take a look at the peer data. The average margin-at-risk is –7.8% and the lowest in the typical range is –4.0%; A limit of –1.5% would be way too tight.

C) Eliminate the Net Income-at-Risk policy altogether If the bank doesn’t have any significant interest-sensitive items that it reports below the margin then what’s the point of the net income-at-risk policy? Fundamentally rate changes impact margin so set your policy limits using net interest margin. There are too many other factors that will skew the net income-at-risk numbers. In this case it’s a high provision expense, but it could have easily been a high or low security gain/loss, or an unusual expense item. Net income is already quite small compared to margin for most banks. Anything that significantly reduces the ratio of net income to margin will wreak-havoc on the net income-at-risk measurement.

After writing this out I think I’d prefer option C. If the regulators don’t like that, then choose option A. If option A won’t fly then option B, but option B would be a real pain.

Comments

Brad,
We have seen some commentary from our examiners related to Net Earnings at Risk. We have been outside our risk limits for a number of years, with it worse more recently due to higher provision expenses (similar to the bank you talk about in your post). We are talking about changing our Net Earnings at Risk limits. What policy limits to you see from banks in your universe?

A -40.0% ALCO limit for EAR is not that unreasonable. Especially if as an industry we’re going to continue with a high level of provision expense. If your EAR measurements are falling outside -40.0% I’m guessing it’s due to abnormal levels of provision and other non-interest expense. If so, document the anomaly along with what you expect a more “normal” level of expense to be.

If the elevated overhead levels are not an anomaly I think there may be more than ALCO policy to worry about. Such levels of overhead are probably not sustainable.